MAY 2012 Balance tempers credit risk
Schroders’ global credit research has expanded to incorporate greater macroeconomic analysis, resulting in key hirings to achieve a ‘more balanced attack’ in generating returns
KARL DASHER Head of fixed income, Schroders
Schroders’ strategic thrust into fixed income as a specialist asset class began more than a decade ago. Fundamental research of companies has always been a key component of the firm’s equity division, so extending that into credit analysis was a natural evolution. The group built a global credit research plat- form, extending across Europe, Asia and the Americas, that has been the engine of growth for Schroders’ fixed income proposition.
This has chimed with investors, who are increasingly recognising that corporate credit is an important way to add value in fixed income markets. Karl Dasher, the head of fixed income at the group, says: “While our view on the attractiveness of the asset class (and thus our exposure to it) will ebb and flow over a cycle, the credit risk premium can add 1%-2% per year in additional returns above govern- ment bond returns through the combi- nation of the return of the risk premium itself and the active manage- ment of that risk premium.” More recently, however, the fixed income team has expanded its focus to incorporate greater macroeconomic analysis, recognising that relying on fundamental credit research is not enough in the present market environ- ment. The key source of volatility in markets today is macroeconomic, rather than credit driven.
This new focus has resulted in a number of new hirings, including a chief investment officer of fixed income, a head of macro, a head of Asian fixed income, and hirings on the emerging market debt team. Dasher says that the aim was to create “a more balanced attack” in gen- erating returns.
He adds: “While we may not be on the cusp of a secular bear market in bonds, we are certainly, in real return terms, at the end of the secular bull market in bonds, and the need to find additional sources of return for investors within the fixed income domain has never been greater.” The group takes the view that in
future the only approach likely to gen- erate a real return will be through actively sourcing returns through credit spreads; actively managing macro factors; and insuring that both of these functions work in concert. Dasher says that duration manage- ment has been the most important fac- tor in driving returns over the past 30 years. Although he does not see fixed income markets as being on the brink of a significant reversal in fortune – pointing out that the Japanese experi- ence holds some relevant precedents – he reckons continued volatility within a relatively narrow trading range and a below-inflation return on govern- ment bonds is likely. This environment will suit Schroders’ approach. Dasher says the process Schroders uses in its efforts to generate better risk-adjusted returns incorporates various elements. “We have developed quantitative tools that help to deter- mine signals in valuation and momen- tum as well as tools to help decide the ideal way to construct a portfolio that will be as robust as possible across a number of market environments. These tools and capabilities are espe- cially important for our Libor-plus strategies.
“We are not a quant shop, but we believe in a disciplined approach and have a great appreciation for what the more quantitative and systematic approaches can add to our portfolios.” The present environment demands clear thinking, Dasher says. The world’s central banks have engineered the greatest refinancing window in history for companies, governments and people, leading to an exceptionally low corporate default rate despite tepid growth. Marginal businesses with poor capital structures that would normally have gone into bankruptcy survived as a result.
While Dasher says he is not com- placent about default risk – the group has close to 30 credit analysts around the world who focus solely on avoiding the companies likely to default – he con- siders that the primary drivers of risk today are macroeconomic rather than company specific.
He says that investors are still well- compensated for default risk. He adds: “We believe that to generate the best risk-adjusted return, fixed income managers have to break down the mar- ket segmentation issue across multiple
dimensions – across industry; across ratings categories (investment grade and high yield); and across markets – and increasingly that means across both developed and emerging markets holistically. We want to ensure we have the specialist skills and experience to find value in all these areas.” Most recently that has meant new investment in the group’s emerging market debt team, which Dasher reckons continues to be a secular opportunity. The group has also added expertise in currency management, seeing this as an important source of returns in future fixed income markets. Dasher says that this is an interest- ing time for corporate bonds in which some blue-chip, high free cashflow gen- erative companies now have higher dividend yields than their long-term bonds yield. At the same time, compa- nies are being cautious with their bal- ance sheets – the memory of 2008-09 is seared in their consciousness. They have fought shy of trying to generate higher returns on equity through tak- ing on higher debt because if they do so the environment may turn more nega- tive for bond investors. He adds: “That is why investors can’t simply rely on simple risk metrics such as quality of revenues or ratings from the credit agencies to decide how to minimise risk at the portfolio level.”
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We are, in real terms, at the end of the secular bull market in bonds, and the need to find additional sources if return within the fixed income
domain has never been greater
Overall, the group is positioned towards corporate credit. Cycles in cor- porate credit are getting shorter, with spread movements that used to occur once every 3-4 years now happening annually. In general, as a result of fac- tors ranging from regulatory changes to macro uncertainty to liquidity, credit spreads are likely to be higher than historically, but with much more volatility. Dasher also likes some Asian and emerging local currency debt mar- kets because investors have two ways to win – in terms of the higher yield, and in the potential for currency appre- ciation. He adds: “A number of the emerging market currencies have had steep corrections of up to 30%, generat- ing a good entry point for investors.” The Schroders fixed income team has grown to be able to take advantage of the widest possible set of opportuni- ties. This is likely to be vital in an envi- ronment where fixed income returns will be harder won. Active manage- ment of all potential sources of return is a sound policy for the future.
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